System constraints in the back office and a lack of experienced staff are exposing fund managers to greater risk as they boost investments in over-the-counter derivatives, a report has warned.

OTC derivatives trading, which is transacted between hedge funds and brokers or the dealing desks of investment banks, continues to grow. The latest available data suggests there was $34 trillion (€25 trillion) outstanding in credit default swaps at the end of last year, their value having grown 240% in 18 months.

They are also becoming more widely traded, as traditional long-only asset managers have increased their exposure to these complex, bespoke instruments.

According to the report, OTC Derivatives – Simplifying the Complexities, by Cor FS, a system vendor, shortcomings were being overlooked. Lee Runciman, its author, said: “In many institutions there are restrictions on the number of OTC deals that can be executed because of the lack of capacity for the back office to perform the necessary confirmation and settlement processes.”

He said this lack of capacity was one of the main drivers behind investment in systems for handling OTC derivatives because “there are few forces known to man greater than the will in the front office to add alpha”.

These system concerns were exacerbated by “a severe lack of staff experienced in performing the necessary valuation, confirmation and settlement processes for OTC trades”, according to Runciman.

Lack of qualified middle and back-office staff was exacerbated by the fact that as institutional money managers move into OTC derivatives there were more companies fighting over these few individuals.

An option for the buyside is to outsource these requirements to third parties, such as custodian banks or fund administrators, but they face the same problems as their clients in attracting top staff.

However, the market is maturing. There are decent systems available to buyside institutions but this proliferation brings its own challenges.

There are established post-trade processing systems in each type of OTC derivative – the Depository Trust & Clearing Company’s DerivServ for credit default swaps, SwapsWire for interest rate swaps and LCH.Clearnet’s RepoClear for repos – but these systems do not necessarily interface well.

Runciman said: “Banks are using different systems for different instrument types and find they have seven or eight systems all doing broadly the same thing for instruments that are only slightly different in terms of how they are confirmed.”

Runciman drew a parallel with the situation in the equities markets 15 years ago, as share trading volumes overwhelmed banks’ underfunded middle and back offices, creating “a compelling reason for automating the post-trade confirmation and settlement process, which was labour-intensive”.

Thomson Financial, a system and data vendor, was first to spot this, bringing to market a trade-matching system, while Swift, the standards bearer for back-office messages, played its part.

Systems, such as DerivServ and SwapsWire, are already available and messaging standards are emerging, administered by the International Swaps and Derivatives Association, the trade body, but the report warns against ignoring the lessons of the past.

Runciman said: “We need to be careful that we don’t miss the trick of leveraging the knowledge and experience of the past when we search for solutions to the challenges of today.”